Tax Incentives for Alcohol Fuels

Salvatore Lazzari
Specialist in Public Finance
Economics Division

February 9, 1995

95-261 E

SUMMARY

The Federal tax code contains five tax incentives that benefit alcohol fuels: the 5.4¢ per gallon excise tax exemption, the 54¢ per gallon blender's tax credit, the 10¢ per gallon small ethanol producers' credit, the income tax deduction for alcohol-fueled vehicles, and the alternative fuels production tax credit. These tax incentives were enacted to encourage substitution of renewable alcohol fuels for gasoline and diesel, to conserve petroleum in the transportation sector, and reduce dependence on petroleum imports. The blender's tax credits were specifically enacted to complement the excise tax exemptions, so as to help support farm incomes by finding another market for corn, sugar, and other agricultural products that are the basic raw materials for alcohol production. More recently, proponents of expanding the alcohol fuels tax incentives argue that they reduce smog and improve air quality.

EXEMPTIONS FROM THE MOTOR FUELS EXCISE TAXES

The most important tax incentive for alcohol fuels, the one most responsible for the development of the alcohol fuels market, is the 5.4¢ per gallon exemption from the excise taxes on gasoline. The Internal Revenue Code (IRC) imposes a tax of 18.4¢ per gallon of gasoline, composed of an 11.5¢-highway trust fund rate (which finances the Federal Highway Trust Fund), a 6.8¢-deficit reduction rate (which is designated to the general fund for deficit reduction), and a 0.1¢-Leaking Underground Storage Tank (LUST) trust fund rate.(1) In addition, the IRC imposes tax on diesel and a variety of other motor fuels used in highway transportation, with the tax rates varying by type of fuel and its use. Diesel fuel, for example, is taxed at 24.4¢ per gallon.(2)

The excise tax exemptions for alcohol fuels apply to both blended fuels and straight alcohol fuels. Mixtures of motor fuels and biomass-derived alcohols (either methanol or ethanol produced from plants and other renewables) are partially exempt from the 18.4¢-tax, with the amount of the exemption depending upon the fraction of alcohol that is in the mixture and the type of alcohol. Gasohol mixtures—blends of gasoline and ethanols that are 10% ethanol (3) that are taxed at 13.0¢ per gallon (or are exempt from 5.4¢ of the tax). Mixtures that are 7.7%. ethanol are taxed at 14.24¢ per gallon (or are exempt from 4.16¢ of the tax). And finally, mixtures that are 5.7%. ethanol are taxed at 15.32¢ per gallon (or are exempt from 3.08¢ of the tax). (4) The 5.7% and 7.7%. blend correspond, respectively, to the 2.0% and 2.7% oxygen content standard for gasoline sold in ozone nonattainment areas and carbon monoxide nonattainment areas under the Clean Air Act. Alcohol blended with diesel or one of the other special motor fuels is also partially exempt from tax.

In order to qualify for the exemptions, the alcohol must be at least 190 proof (95% pure alcohol, determined without regard to any denaturants). Second, for the blended fuels, the alcohol cannot be derived from petroleum, natural gas, or coal (including peat). Nominally, both ethanol and methanol qualify for the exemption. In effect, however, only ethanol is tax exempt because most of the economically feasible methanol is derived either from natural gas or coal, which does not qualify for the exemption for blended fuels. Thus, methanol produced from wood, urban waste, and other biomass would qualify for the exemption, but very little methanol is actually produced from these sources because it is generally uneconomic.(5)

Mixtures of gasoline and ethyl tertiary butyl ether (ETBE) would also qualify for the excise tax exemption under a proposed IRS rule. ETBE is a chemical compound derived from ethanol. It is the result of a chemical reaction between ethanol (which may be produced from renewables) and isobutylene, a byproduct of both the petroleum refining process and natural gas liquids. In this reaction, the ethanol is chemically transformed and is not present as ethanol in the final product. The IRS proposal would permit mixtures containing 12.7% ETBE (equivalent to 5.7% alcohol) to qualify for the 3.08¢-exemption.

Straight alcohol fuels -- mixtures that contain a minimum of 85% alcohol -- also qualify for the excise tax exemptions at varying rates. There are three categories. For biomass-ethanol, the tax rate after the exemption is 12.35¢, consisting of a 5.5¢-highway trust fund rate (a 6.0¢ - exemption), the 6.8¢-deficit reduction rate, and a 0.05¢-LUST fund rate. For biomass-methanol, the tax rate after the exemption is 12.95¢ per gallon, consisting of a 6.1¢- highway trust fund rate (a 5.4¢-exemption), the 6.8¢-deficit reduction rate, and the 0.05¢-LUST fund rate. In the case of 86% alcohol (ethanol or methanol) derived from natural gas, there is a separate motor fuels tax exemption of 7.0¢ per gallon [the tax rate is 11.4¢ per gallon (§4041(m))]. (6) (Note that the LUST fund rate on these 85% mixtures is one-half the rate that applies to all other taxable fuels [4041 (b)(2)].) As before, the alcohol cannot be derived from petroleum or natural gas. However, in the case of straight alcohol fuels, the alcohol may be derived from coal. The excise tax exemptions for alcohol fuels expire on October 1, 2000.

INCOME TAX CREDIT FOR ALCOHOL USED AS A FUEL

In addition to the excise tax exemptions, the current Federal tax code provides for an income tax credit for alcohol used or sold as a fuel. This credit is available for both alcohol blended with a motor fuels (mixture) and for straight alcohol used as fuel.

The alcohol mixture (blender's) credit is a tax credit available to the blender for alcohol blended with gasoline or any other liquid motor fuel. The credit is 60¢ per gallon of alcohol if the alcohol is methanol and if the alcohol is at least 190 proof, and 45¢ if the methanol is between 150 and 190 proof. No credit is available for methanol that is less than 150 proof. If the alcohol is ethanol, the credit is 54¢ per gallon if the alcohol is at least 190 proof, and 40¢ if the alcohol is between 150 and 190 proof. This mixture credit is available only to the blender, who must not only produce the mixture but must either use the mixture as a motor fuel in a trade or business or sell it for use as a fuel. The blender may be either the producer, the terminal operator or the wholesaler. The alcohol fuels tax credit is also available for straight (nonblended) or neat alcohol fuels. The amount of the credit is the same as above, depending upon whether ethanol or methanol is used, and depending upon the proof of the alcohol. This alcohol fuels tax credit is a credit to either the user of the fuel in a trade or business or to the retail seller of straight alcohol fuels, as long as it is placed in the fuel tank of the buyer's vehicle.

The alcohol fuels tax credits apply to most types of ethanol (i.e., alcohol derived from renewable energy resources such as vegetative matter, crops, and other biomass), including methanol derived from wood and other biomass sources. There are, however, a number of restrictions. First, as with the excise tax exemptions, the alcohol cannot be derived from petroleum, natural gas, or coal (including peat). And as with the exemptions, this limitation effectively means that the credits are currently available only to ethanol, since most economically feasible methanol is made from natural gas. Second, and most important, the credits are offset by any excise tax exemptions claimed on the same fuel. Taxpayers must choose between the exemption or the credit; they cannot claim both incentive on the same quantity of blended fuel. Third, under IRC §87, the alcohol fuels tax credit is itself taxable as gross income for the tax year in which the credit is earned. Thus, a taxpayer that claims the credit has to add it back as income subject to tax and the net value of the credit is reduced below the gross value. Fourth, the alcohol fuels tax credit is a component of the general business credit under IRC §38, which includes the targeted jobs tax credit, research and development tax credit, low-income housing tax credit, and other credits. Fifth, the credits are not refundable; they may be used only against a positive tax liability; they are of no value if the producer has no tax liability.

In 1990, the IRS ruled that blends of ETBE and gasoline (or other motor fuels) would be treated as alcohol fuels mixtures and, therefore, would qualify for the income tax credit. Allowing ETBE to qualify for the blender's tax credit is designed to stimulate the production of ethanol for use in reformulated gasoline, which would reduce the growth of methyl tertiary butyl ether (MTBE) production. The two blender's tax credits have been available continuously since 1980 and they are scheduled to expire on January 1, 2001.

ETHANOL TAX CREDIT FOR SMALL PRODUCERS

Current law provides for an income tax credit of 10¢ per gallon ($4.20 per barrel) for up to 15 million gallons of annual ethanol production by a small ethanol producer, defined as one with ethanol production capacity of less than 30 million gallons per year (about 2,000 barrels per day). This credit is strictly a production tax credit available only to the manufacturer who sells the alcohol to another person for blending into a qualified mixture in the buyer's trade or business, for use as a fuel in the buyer's trade or business, or for sale at retail where such fuel is placed in the fuel tank of the retail customer. Casual off-farm production of ethanol does not qualify for this credit.

The small ethanol producer credit is limited in the same way as the blender's tax credit. The amount of the credit is reduced to take into account any excise tax exemption claimed on ethanol output and sales.

TAX DEDUCTION FOR CLEAN FUEL VEHICLES

The Energy Policy Act of 1992 (P.L. 102-486) created a new Federal tax deduction for clean-fuel-burning vehicles, including vehicles that run on alcohol fuels. the This tax deduction has two components: a tax deduction for individuals or businesses that purchase vehicles that run on alternative fuels; and a tax deduction for businesses that invest in equipment for storing and dispensing the clean fuel and otherwise refueling the clean fuel burning vehicle.(7)

In the first incentive, taxpayers can deduct from adjusted gross income a portion of the costs associated with the purchase of dedicated alternative fuel vehicles (AFV's), or the costs of converting vehicles so that they can operate on clean-burning alternative fuels (dual fuel AFVs) in addition to gasoline. Dedicated AFV's are new vehicles designed to run on an alternative fuel only. For dedicated AFVs, costs up to $2,000 for qualified property can be deducted for a vehicle up to 10,000 lbs., up to $5,000 for a truck or van of 10,000 to 26,000 lbs., and up to $50,000 for a truck or van over 26,000 lbs. Qualified property for a dedicated AFV includes the full cost of the engine, the fuel delivery system, and the exhaust system. For a dual-fuel vehicle, the qualified cost is limited to the incremental cost of the same components compared with the systems for conventional fuels.

A second clean fuel tax incentive is provided for the installation of refueling equipment for alternative fuels. Up to $100,000 of the cost of installing alternative fuel storage and dispensing equipment could be deductible per year. Qualifying property includes equipment usually purchased by retail service stations and associated with the storage and dispensing of the alternative fuel into the AFVs.

For both of these tax incentives, alternative fuels are defined as compressed natural gas, liquefied petroleum gas, liquefied natural gas, hydrogen, electricity, and any other fuel that includes 85% alcohol fuels, ether, or any combination of these. In addition, all of the property that qualifies for the deduction -- either the new vehicle, the conversions equipment, or the refueling equipment -- must be new. Qualifying vehicles must meet any applicable Federal and State environmental standards. For business taxpayers, the basis of the property for purposes of the depreciation deduction is reduced by the amount of clean-fuel-vehicle deduction.

In general, each of these deductions terminates at the end of 2004. But there is a phase-out provision in the case of new clean-fuel burning vehicles or retrofit equipment. The deduction is phased-out evenly over a three-year period beginning in January 2002.

THE ALTERNATIVE FUELS PRODUCTION TAX CREDIT

Production of certain types of alcohol fuels may qualify for a non-refundable income tax credit. The credit is also available for a broad variety of fuels derived from various alternative energy resources (such as oil from tar sands or shale, gas from coalbeds, brine or tight formations). This is the alternative fuels production tax credit, also known as the section 29 tax credit.

Certain types of alcohol fuels -- alcohol produced from coal and lignite --could qualify for this credit. Thus, both ethanol and methanol could technically qualify for this credit, although, in reality, there is little if any production of synthetic fuels from coal. Moreover, alcohol fuels produced from coal or lignite may be used as feedstocks, unlike other fuels, without invalidating the tax credit. Alcohol fuels produced from biomass do not qualify for this credit.

Every barrel of qualifying fuels (including alcohol fuels) receives a credit of about $6.00 per barrel; $3.00 in real terms (using 1979 as the base year and the GNP deflator as the price index). (8) The availability of the credit depends on the price of oil. When oil prices are high, the credit is not available because high oil prices are enough economic incentive for the market system to develop alternative fuels on its own. In contrast, when prices are low the credit becomes available because low oil prices mean that the economic incentive just is not there to justify development of alternative fuels. More specifically, the tax credit is determined by comparing the average wellhead price of domestic crude oil (called the reference price) with a trigger price. When the reference price of oil is below $23.50 (in real terms, again using 1979 as a base year), the tax credit becomes available; when the price of oil is between $23.50 and $29.50, the credit is phased-out proportionately; when the price of oil is above $29.50, no credit is available. These trigger or threshold prices are adjusted for inflation so that a comparison may be made with the reference price in nominal terms. For example, in 1987, the market price of crude oil (the reference price in nominal terms) was $15.41 per barrel, well below the $35.13-reference price ($23.50 times the inflation adjustment factor of 1.4949). Thus the alternative fuels credit was available. In current dollars, the credit was about $4.50 per barrel in 1987 $5.35 per barrel in 1993, and $5.70 in 1994.

The alternative fuels production credit is generally available for fuels produced before year 2002. However, for all fuels except biomass gas and synthetic fuels, the production facilities (or wells) must be placed in service (or drilled) after 1979 and before 1993. This is the placed-in-service rule. For biomass gas and synthetic fuels, fuel production must be placed in service before 1996. Thus, prospective producers of these two types of fuels will have through December 31, 1995, to build a facility and begin production provided that there is a binding contract to that effect.

This credit is reduced in proportion to any subsidized energy financing (grants, loans, tax-exempt financing) which may be used. This is done to prevent "double dipping." This credit is also reduced "dollar-for-dollar" by the enhanced oil recovery credit of section 43 and by any business energy tax credits claimed for equipment which is used to produce the fuel to the extent that this credit is still being claimed.(9)

Endnotes

1. The LUST trust fund is a Federal program that finances the cost of cleaning up spills from underground fuel tanks.
2. The expiration dates for the motor fuels excise taxes also vary depending on the component of the fuel in question. See U.S. Congress. Congressional Research Service. Alcohol Fuels Tax Incentives and EPAs Renewable Oxygenate Requirement. CRS Report 94-785E, Oct. 7, 1994, by Salvatore Lazzari. Washington. p 3.
3. Although under the IRC blends of gasoline with biomass-derived methanol would also qualify, such blends are disqualified under the Clean Air Act because of the associated increase of emissions of ozone-forming pollutants.
4. In all these cases, the exemption equates to 54¢ per gallon of ethanol used.
5. As a practical matter, there is little if any production capacity for methanol produced from biomass resources.
6. This partial exemption had the effect of equalizing the Federal tax rate for methanol to that of gasoline on an energy-content (Btu) basis prior to the Omnibus Budget Reconciliation Act of 1993 (OBRA). OBRA, however, increased the gasoline tax by 4.3¢ per gallon, which on a gasoline-equivalent basis would be 8.6¢ per gallon of methanol.
7. For a complete discussion of these provisions see: U.S. Library of Congress. Congressional Research Service. Energy Tax Provisions of the Energy Policy Act of 1992. CRS Report 94-525E, by Salvatore Lazzari. Washington, 1994.
8. Technically, the amount of the credit is linked with the BTU (British Thermal Unit) content of oil. Each 5.8 million BTU's of fuel qualifies for the $3.00 credit.
9. These business energy tax credits have expired but they may still be available as carryovers of unused credits.